The Road to Global Monetary Debasement

Businessman holding the world

In today’s Daily Reckoning, we’re going to look at China’s recent ‘monetary easing’ and show you why it’s not as straightforward as it looks.

But first, some local news…

The Aussie market is on a tear. Today’s gain marks the 12th straight rise in the ASX 200 index, which I think sets some kind of record for consecutive daily gains.

The stock market is turning into some weird sort of bond market, where everything is assessed on yield first and actual fundamentals second. That’s good for now, dangerous later…

You can’t argue with the price action though, even if you disagree with it. The ASX 200 broke out to a new, post 2008 high on Tuesday and has kept going. This suggests that we’re set for another leg up in the bull market…after pretty much going sideways for a year.

Of course, you don’t get 12 straight rises (and a gain of nearly 550 index points in little more than two weeks) without giving some of it back to profit taking in subsequent weeks. But the bulls are firmly in control here. Thanks to the market having more faith in central bankers than they do in God, the bulls look like they’ll stay in control for the time being.

One bloke who isn’t in control is Tony Abbott. He’s lost his grip big time. The Fairfax media reports this morning that Malcolm Turnbull sought a meeting with Abbott, apparently to find out exactly how Tony was going to get the party back on track.

Who knows what went on? And you certainly wouldn’t believe a word of their public utterances. What’s clear is that Abbott is bleeding profusely and the sharks are swarming.

Next week looks like it will a crucial one for his leadership. If the Liberal Party had any brains, they’d promote Malcolm Turnbull, as he has the greatest chance of appealing to the marginal Labor voter. But the Liberal leadership is full of right wing ideologues following an anachronistic, conservative agenda.

In other words, they’re all foaming-at-the-mouth idiots who are completely out of touch with most of Australia. The only reason Abbott won power was that the other side was less than useless. That’s how politics seems to work these days…you win office based on the weakness of your opponent, rather than your strengths.

Isn’t it funny how the quality of leadership and of politics in general in this country has deteriorated along with the economy? With economic conditions set to get even worse in the years to come, does this mean we have to put up with more political pathetic-ness?

Chances are the answer is yes. Great leaders generally emerge out of times of economic hardship. Just like an addict needs to hit rock bottom before they take the necessary steps to recover, so too an economy needs to go through tough times before the majority of people wake up and demand genuine change.

You could draw the same parallel with what’s happening on a global scale. Our reverence of central banks and money printing will only be exposed as false once their policies basically destroy the system.

It’s abundantly clear that cheap money is a cancer on the economy, that it destroys the value of money (in relation to asset prices, if not consumer prices) and that it simply doesn’t work.

But we’re so far down the road in this monetary experiment that to stop now would be akin to going cold turkey halfway through the party. Cold turkey only works once you’ve hit rock bottom. That’s when the will to change is greatest, and not a minute before.

So we’re on the road to global monetary debasement…first against asset prices and then against everyday goods and services. The latter could take another few years though…

In the meantime, sit back and enjoy the central bank show. If you want to profit from it, here’s an intriguing way to do so. My mate Tim Dohrmann, editor of Australian Small Cap Investigator, has found a number of stocks that allow you to ‘invest like a millionaire’. Click here for more…

The latest central bank to try and ‘do something’ is the People’s Bank of China (PBoC). Although it is hard to keep up; the Danes cut interest rates last night for the fourth time this year in a futile attempt to maintain their peg with the euro.

That’s partly the reason behind China’s latest move too. I wrote here a few weeks ago that I thought the yuan/US dollar peg would be the next to go…another casualty of the global currency wars.

This week, the PBoC lowered the amount of reserves that banks are required to hold against its deposits, which frees up around 500 billion yuan for potential new loans.

The mainstream media hailed this as monetary easing but in the scheme of things, an additional 500 billion yuan in loans is tiny. Look at the Chinese stock market’s reaction…it fell on the news.

To see why this news might not be so bullish after all, you have to understand the effect of the yuan/US dollar peg.

The initial pegged exchange rate undervalued the yuan, which lead to China generating massive trade surpluses and foreign exchange reserves.

What many people don’t realise is that those reserves form the backbone of China’s financial system. They don’t sit on some vault somewhere, available for a rainy day when China really needs them. Not exactly, anyway.

Here’s how it works, roughly…

When US dollars flow into the country, the PBoC must print yuan to maintain the exchange rate peg. The dollars go into the foreign exchange vault, and the newly printed yuan go into the Chinese banking system as commercial bank reserves.

Just think of it as double entry accounting. On the one side, you have an asset (the FX reserves) and on the other you have a liability, which are the domestic banking reserves.

As these assets and liabilities grew (thanks to the pegged exchange rate), China had to do something to stop all the newly created bank reserves flowing into the economy and leading to an inflation blow out. So they started increasing the reserve requirement. That is, they made banks hold more and more cash as reserves.

This chart from the Financial Times is an old one but good enough for our purposes. It shows how the reserve requirement (RR) for large banks increased over the past decade from around 7.5% to over 20%. The recent move brings it down to 19%.

So, thinking about it simplistically, the RR went up as China’s foreign exchange levels (and domestic bank reserves) went up. But now, that trend could be changing.

Bloomberg reports that in the fourth quarter of 2014, capital outflows in China were the largest since 1998. That’s not as extreme as it sounds, because it wasn’t a huge amount (US$90 billion), but it is unusual.

It suggests that speculative capital sitting in China hoping for a yuan revaluation might be starting to leave. This is a drain on domestic liquidity. When your economy is suffering from a credit binge hangover, liquidity constraints aren’t welcome.

As far as I can tell, the RR cut reflects an attempt to maintain liquidity and offset the effect of capital flight, rather than act as a monetary stimulus.

The bad news is that you can probably expect to see capital continue to leave China as the yuan’s peg to a dollar bull market takes its toll on China’s economy. The good news is that China has considerable defences against this and can lower the RR for some time to come.

The message? Don’t get too excited. China is in a long fight to keep its economic head above water after an epic credit boom.

For that matter, so is Australia.


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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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3 Comments on "The Road to Global Monetary Debasement"

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slewie the pi-rat
slewie the pi-rat
1 year 8 months ago
Lenin [Vlad, not John] was of the opinion that debasing the currency was THE most sure-fire way to destroy “CapitalISM”. slewienomics observes that’s it now appears to be a pretty damned good was to destroy “SocialISM”, too. of course, what difference would that make, to unhhh… FascISM? hut. hut. hut. anyhow, the checks are in the mail, so don’t mess w/ success, eh? have a nice week-end, and, as always, try to be polite. and maybe check out this fabulous tree-shaking: Treasuries and Gold & Co. seem to be the fallen fruit, right now… oh—and the Yen, of course…,… Read more »
1 year 8 months ago

How do you debase something that is intrinsically worthless? It is confidence that gets eroded.

1 year 8 months ago Greg. Mate. I’m no fan of Abbott, but Turnbull only appeals to the Labor voters in opinion polls. Having him as PM would erode the Liberal support base giving Labor and the Greens full control of the house and senate whose only course of action on economics is borrow more and spend more – even during a economic boom. Seeing how those two parties and the Palmer United Party are the major thorn in the way of controlling our debt, this should give anyone with an IQ over single digits the heebie jeebies. And let us not forget that… Read more »
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